Introduction - did the Fed get it wrong?
I believe that it is no coincidence that the Fed's tightening - reversal of QE andmany rate hikes - is coinciding with deflationary action in several asset classes. Yet Chair Powell said last month that reverse QE was going very well. Not long before that, he said that the Fed might tolerate an inverted yield curve.
On top of the Fed's action are several major issues. One is the trade wars; this may be short term in nature (who knows?) but at least some business decisions have been put on hold in the US, and in the EU and China related to changing US policies. Another is Brexit. Yet another looks bigger to me, as it goes back to 2012: QE 3 and the quasi-bubble effects it caused.
Let's get to specifics with a focus on interest rates, i.e. bond prices, which move up when interest rates drop.
Fund Managers Are Acting as They Did Just Before the Last Two Recessions
A graphic I found reporting on a BofA Merrill Lynch graphic showing highly bond-bearish positioning found in a survey of fund managers sums things up for me beautifully (entire blog post here):
Money managers, who are smart and well-informed, may be making a turn back to bonds (safety) from risk-on assets that have served them so well the past decade.
This chart has helped to clarify my thinking about such assets as intermediate Treasuries (IEF) and very long term Treasuries (TLT).
The solid black line shows that just as in 1999-2000 and again in 2007, fund managers have been heavily underweighted in bonds. However, more difficult to see, the light blue lines show that as occurred in late 2007, managers added lots of bonds, moving from 58% underweight to "only" 35% underweight.
Message: money managers are acting on both the above metrics just as they did as the Great Recession was getting underway, and with regard to the metric measured by the black line shortly before the 2001 recession began.
In view of the issues discussed in the introduction, this strikes me as bond-bullish.
Next, a different correlation, from a presentation prepared in late November.
More People Are Seeing the Massive Bearish Sentiment on Bonds at What Might Be a Turning Point for Rates
A detailed post by Knowledge Leaders Capital titled The Fed is Tightening More than it Realizes shows the following (slide 20, which also shows a somewhat busy graph):
Our friend Jim Finucane of Finucane Financial pointed out to us that all good lows in long US Treasury bonds [lows in bond prices = peaks in yields] occur after the Consensus Inc. survey has been under 40% for an extended period. For example, good lows in 1984, 1987, 1990, 1994, 2000, 2007, 2011, 2013 were preceded by 20-38 weeks under 40%.
As of 11/23/18, we’ve been under 40% for 41 weeks—the longest stretch in history. The only example that comes close is the 38 weeks under 40% that preceded the 2000 low.
This observation is consistent with the prolonged extreme bearish positioning by speculators in the 10 year and 30 year Treasuries on the futures market.
Thus, this and the prior section suggest to me that trading dynamics may favor the out-of-favor asset class for a while.
Time to Go Risk-Off?
At the end of a long expansion, the Fed and traders are all on the side of unending growth and inflation. So the Fed restricts credit and makes cash more competitive with more long-lived financial assets to restrain animal spirits. But the Fed can go too far, especially given other things happening. In 1999-2000, there was massive over-spending on fiber optic cables, semiconductors as well as office buildings. The Fed tightened and poof: tech and telecom went into a depression, causing the economy as a whole to go into recession. By 2006, seriously poor lending practices in housing met up with 17 rate hikes in only 25 months. The result was a depression in housing and finance, and the financial crisis.
Now, consider that there was so much money already deployed via prior QE's that when QE 3 got rolling in 2013, gold and silver were already fully priced and actually declined. Where did all the QE money go, then, if not into traditional inflation hedges? I would say it went everywhere: housing, shale oil, biotech and software start-ups, etc. And certainly into financial asset prices. Now, we see things we saw in 2001 and by Q2-3 of the Great Recession. Dr. Copper is sick again. Crude oil is sick, but stock prices of most companies that should benefit from lower prices, such as the transports, are sick as well. An example from Tuesday is FedEx (FDX), which I own. From its press release, the founder and CEO said:
“While the U.S. economy remains solid, our international business weakened during the quarter, especially in Europe. We are taking action to mitigate the impact of this trend through new cost-reduction initiatives.”
One of these initiatives involves reducing international network capacity. That reflects weakness of some significance in FDX's view of the ex-US economy.
We have evidence of significant deceleration of economic activity in the US, but worse than that ex-US. There will be many causes of that phenomenon. My view is that the many strengths of the US coupled with a nationalist policy by the administration and the Fed "making the dollar great again" are major causes of this. A global recession may be signaled by the action of foreign markets. In one example, the SPDR Euro Stoxx 50 ETF (FEZ) has dropped nearly 25% from its January peak. That begs the next question...
Is Much of the Developed World in Recession Already?
A well-known research shop, Ned Davis Research, thinks this is likely. I track this analysis via a money manager and advisory firm, CMG Wealth, which has been updating the copyrighted NDR model for global ex-US recession risk. As of last Wednesday's update, CMG said that:
The current [model] reading is 81.96, meaning there is an 81.96% probability that we are in a global recession.
They also noted that per NDR's data going back to 1970, whenever the model has shown over a 70% recession risk, there in fact has been an OECD-defined global recession 91.5% of the time.
So I think it's reasonable to look at markets from the standpoint that the Fed has been tightening, and the European Central Bank plans to tighten by removing QE in two weeks, in the face of a possible existing global recession.
What About the US?
A recession represents the end of an up-wave in economic activity and the beginning of something worse than a plateau. Many or most recessions are not recognized until they are well underway; then prior GDP data gets revised downward. As late as early September 2008, the 10th month of the Great Recession, a number of experts were wondering if the collapse of the housing industry would push the US into recession.
So I would say that the combination of a possible ongoing global recession and the lagged effects of a stringent Fed tightening raise the risks that the US is in recession or could go into one next year. That's all I can say at this point on that specific point, but I think that even a slowdown in the US without a recession could roil markets and lead to a bond bull market.
Now, to the markets and my update of the case for cash I have been making since February to a case for long high quality bonds for capital appreciation.
Stocks and Junk Bonds Fully Played Since 2009
We have seen three sub-cycles in the stock market (SPY) since the Great Recession ended. These involved:
- a rush into inflation hedges (QE 1 and 2, 2009-11)
- growth stocks (tech and biotech), and housing stocks (QE 3 and its after-effects, 2012 into H1 2015)
- cyclicals (2016-8), finally with defensives taking over the last several months.
By now, I believe that every stock market sector has had at least one good whirl around the dance floor and could be tired.
In bonds, what is the major trend in the past 10 years? Clearly, the star performer has been junk bonds (HYG). A decade ago, they were yielding high teens while the 10-year Treasury was bottoming around 2.1% and the 30-year T-bond was bottoming around 2.5%. Under pressure of QE and yield suppression on cash, and a good economy, high-yield bonds cratered in yield. It was risk-on most of the time in bond-land as with stocks. But for now that party has ended.
Meanwhile, in high-grade bond land, interest rates and therefore values have been stagnant. When the SPY bottomed in March 2009, the 10-year Treasury was around 2.8%, right where it is now.
Cash and bonds have been dramatic laggards in market action the past decade.
All this is occurring while...
Inflation Is Low and Dropping
The CPI has risen 2.2% in the 12 months through November. However, the Fed pays more attention to the PCE inflation numbers, especially with food and energy price fluctuations included. These have been reported through October; per Reuters:
The Fed’s preferred inflation measure, the core PCE price index excluding food and energy, increased 1.8 percent year-on-year in October, the smallest gain since February, after rising 1.9 percent the prior month. It hit [i.e., finally rose to] the U.S. central bank’s 2 percent target in March for the first time since April 2012.
Economists expect the core PCE price index to hover below that target for much of 2019, which they say could see the Fed temporarily halting interest rate hikes.
That was October data. Wholesale gasoline prices averaged about $1.90/gallon in October, but are $1.35 now. So, as the Fed sees it, base money rates around 2.2% right now - before the FOMC meets - are positive for the first time in about 10 years.
Evidence That Bonds May Be Due to Gain No Matter What the Fed Does Now
All the debt that exists has already been created, and essentially all of it has already been used to consume or invest. What is left after all the borrowing and lending can be a weight on economic activity; the major economic stimulus may already have occurred. The balance depends on the unknowable future: how productively has the debt been used? If wisely invested, the debt can be paid back by enhanced future production. If badly invested, then a Minsky moment may await. Numerous, nay infinite, possibilities lie between the happy and the crisis-filled poles. So we shall see. What I am comfortable saying is that after so many rounds of QE in the US, EU and Japan, a certain amount of economic deadwood probably exists. The lagged effects of Fed tightening may already be removing that deadwood and leading to slower growth in the US. The situation may well be weaker outside of the US based on what I am seeing. That process slows economic activity and pushes inflation rates lower.
The last time WTI and Brent crude were at current levels and dropping, now in the mid-$40's and mid-$50's respectively, it was late 2014 and early 2015. The 10-year Treasury was near 2% then. Copper (CPER) is also at late 2014 (and dropping) levels. Gold (GLD) at $1250 is at a level it first reached more than 8 years ago. Thus it is possible that a disinflation or even deflationary process has been set off by the Fed's tightening and other events; and that the ECB's withdrawal of QE next month could exacerbate that process.
Meanwhile, the trade-weighted US dollar index is near 129, which it reached in 2001-2. When it got to that level, inflation plunged and so did interest rates (and so did the SPY).
So a lot of data points could argue for lower, not higher, inflation rates ahead.
So does the ongoing US baby bust.
In summary, certain fund managers have been aggressively underweighted in bonds, just as they were in 2007 before interest rates crashed and inflation turned to deflation, and similarly to their positioning in 2000 before a similar though milder set of events occurred. Bond speculators have also been short bonds for a long time. This is occurring while crude oil prices have been dropping, as some have said was probable.
Meanwhile, the key question of recession should be looked at globally, in that the USD remains the world's reserve currency. If the NDR model has validity, then it is likely that the deflationary effects of global recession will erode inflation and increase global demand for high quality cash and fixed income. A mere slowdown in the US, as occurred in 2015-6, is in my view enough to push more investors to bid up bond prices (and therefore lower interest rates).
The Fed has shrunk the base money supply; see its H.4.1 release for details. By shrinking the amount of cash in bank accounts as well as raising rates, the Fed has made cash a top-performing asset in my humble opinion. The next step in this process could be investors moving from recognizing cash as a valued, safe asset to also recognizing that Treasuries - which are cash deferred in a real sense - may therefore gain value.
Addendum: The FOMC Awaits
By the time you read this, the Fed's FOMC may have made its statement. I may comment on that as well. The Fed often gets things right, but not always. I'm hoping that it recognizes that by raising rates many times in the past three years and shrinking the base money supply, it has already set powerful forces in motion and thus proceeds patiently. Since traders are going to trade against expectations, I'm going to avoid trading on a knee-jerk reaction to the Fed's statement and Chairman Powell's press conference.
Addendum #2: What About Stocks?
Is it a market of stocks, or a stock market? If the former, there are many great companies which can be bought at prices that are off the boil, and long term "should" outperform a buy-and-hold bond strategy. If the latter, and the Fed continues to shrink the money supply, I'm not a bull on asset prices. I'll have more to say on the SPY and other stocks after the FOMC meets.
Submitted Wednesday pre-market, S&P 500 futures 2560, 10-year Treasury 2.82%.